Decoding Chinese VIEs-Riedel Research Takes Shot

By Reshma Kapadia

Variable Internet Entity Structures might as well be the four-letter word for Chinese investors. These widely used structures are sometimes the source of the problem for companies that have been the target of SEC probes. Several analysts have tried to explain the structure and when it can pose problems. The latest comes from emerging market shop Riedel Research.

Analysts write that the VIE structure is used to get around foreign ownership rules in China. Under one of these structures, the operating companies are entirely controlled by corporate insiders and their families. The only rights and recourses shareholders have are dictated in “contractual obligations,” analysts write.

The largest U.S. listed firm that uses this structure: Internet favorite Baidu(BIDU). But it’s by no means alone, with the likes of Sohu (SOHU)Ctrip(CTRP) and DangDang(DANG) also using the structure. In fact, analysts note that 108/230 Chinese firms listed in the U.S. use the structure. (Amazon (AMZN) also uses the same structure to operate in China).

The problems seem to pop up when there is a conflict within the management or shareholding base, which causes a fight for control, the analysts write. New Oriental Education(EDU) was one of the most recent firms caught in the crosshairs, with the SEC looking into the consolidation of certain subsidiaries before confirming they do not have a problem.

Some red flag/favorable factors Riedel highlights:

Equity in the operating VIE should be pledged for performance of responsibilities. The shares would have to go to a domestic individual or entity (rather than to the foreign shareholders) but this is one threat that shareholders can use to ensure compliance. “

“Disclosure of revenue and net income of the VIE: Only about 30% of companies with VIEs disclose the revenue and net income of the VIE. Companies audited by Deloitte disclose this information 80% of the time.”

Stick with situations where no member of management has the power to single-handedly control the VIE; best if shareholders are dispersed across a group of people that are not under control of the same person.

Look closely at board composition, avoiding those where the founder or a relative act as the legal representative of the holding company and the VIE.

”Local management should be incentivized with ownership into the offshore holding company.”

About Emerging Markets Daily

Emerging markets have been synonymous with growth, but the outlook for individual nations is constantly changing. Countries from Brazil and Russia to Turkey face challenges including infrastructure bottlenecks, credit issues and political shifts. Barrons.com’s Emerging Markets Daily blog analyzes news, data and research out of emerging markets beyond Asia to help readers navigate the investment landscape.

Barron’s veteran Dimitra DeFotis has been blogging about emerging market investing since traveling to India and Turkey. Based in New York, she previously wrote for Barron’s about U.S. equity investing, including cover stories and roundtables on energy themes. Dimitra was among the first digital journalists at the Chicago Tribune and started her career as a police reporter at the Daily Herald in the Chicago suburbs. Dimitra holds degrees from the University of Illinois and Columbia University, where she was a Knight-Bagehot Fellow in the business and journalism schools. She studies multiple languages and photography.